Living on borrowed prosperity

A substantial minority of libertarians, and fellow-travelers on the right, view this crisis as just desserts. America has borrowed prosperity from the future, and now the bill has come due. We need to "work the rot out of the system" (an idea that originated with Andrew Mellon, the US treasury secretary whose dealt so ably with the onset of the Great Depression by sailing off to Europe to negotiate over the debts we were owed from World War I).

This does not, to me, make much sense. Sure, monetary expansion can
cause the economy to produce above its natural level of output
temporarily. As the supply of money (i.e. bank credit) rises, firms
expand. They bid up the price of labor. More labor is lured into the
labor market by this money. But of course, it takes labor some time to
produce more goods, and some of those goods are probably combination
flashlight/nose trimmers that no one wants to buy. Workers lured in by
higher wages bid up the price of existing goods. That means that the
money wasn't worth nearly as much as they thought it would be, a
monetary phenomenon you can observe at will by finding someone who is
about to transfer from the Oklahoma City office to New York.

Disappointed, some of the marginal workers who were lured into the
labor force cut back on their hours, or leave the labor force, or at
least spend more time playing computer solitaire because who wants this
lousy job anyway? The ultimate result is higher prices and about the
same level of output. That process of boom and mean reversion takes
about eighteen months to work its way through the system.

But I don't see how it is possible, over the long term, to have a
bubble that consists of "borrowing from our future". We can't get
money from the future--their financial system isn't integrated with
ours. We can commit some people in the future to give others money,
and in that sense our current political happiness with various old-age
entitlements might be said to be borrowed from the future. But we
cannot, ourselves, spend the actual cash that rightfully belongs to
them.

Well, actually we can. We can borrow from foreigners. But America borrows in her own currency, and at pretty low interest rates. Our current account deficit is certainly worrisome, but not "the economy needs to contract by 1/3 to fix it" worrisome. Moreover, we still do most of our borrowing from good old US citizens.

Credit markets don't expand our wealth by borrowing from the future's
precious prosperity reserves. They increase production by vastly
increasing the efficiency of individual savings, funneling them into
long term investments that require larger sums than most individuals
can amass. They do so both by aggregating investments, and by
transforming the duration of the investments--allowing people who want
to lend for six months or seven years, to lend money to people who want
to borrow for fifteen or thirty. This increases the supply of savings,
and hence the supply of investment. But at the end of the day, the
size of the economy is, to a first approximation, the amount of goods
that a society can produce with the available supply of capital and
labor. The composition of these two factors is always changing, of
course, but thanks to the magic of prices, and the law of large
numbers, those changes mostly smooth out in the big picture.

The future being uncertain, that aggregation can result in some
spectacular misallocation of resources between productive sectors. But
even those misallocations aren't that big in the grand scheme of
things. Most of the houses in America, even the new ones, are being
lived in. Maybe their owners would rather have had a new Mercedes, a
rototiller, and a week in Maui. But the utility loss just isn't that
big.